The document provides an overview of technical and statistical analysis concepts such as charts, patterns, momentum, Dow theory, Elliott wave theory, cycle theory, random walk theory, and contrarian theory. It explains tools like moving averages, support and resistance levels, and common chart patterns that technical analysts use to identify trends and time entries into the market. The goal of technical analysis is to forecast future price movements by quantitatively studying historical price data, trading volume, and open interest.

1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 4
Technical and Statistical Analysis
August 2012

2. Chapter summary and outline
This chapter explains the concepts of technical analysis and statistical analysis,
such as charts and patterns, momentum, etc. The chapter also covers other
popular theories of technical and statistical analysis, including Dow theory, Elliot
Wave theory, cycle theory, random walk theory and contrarian theory.
Chapter outline:
• Technical analysis
• Charts and charting
• Dow Theory
• Trendlines and channels, support and resistance
• Volume and open interest
• Major chart patterns
• Statistical analysis
• Elliot Wave Theory
• Cycle Theory
• Random Walk Theory
• Contrarian Theory
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3. Technical Analysis
• Technical analysis tries to forecast future price movements by studying the
price patterns, volume and open interest.
• Quantitative criteria for estimating the relative strength of buying and
selling, determining what to buy and sell, entry and exit points.
Advantages:
• Based on prices which never get revised, needs minimal input (price only)
and is objective.
• A good timing tool
• Helps to instil discipline in trading
Cornerstone of technical analysis:
• Identify a trend via certain chart patterns and performing some statistical
analysis,
• The art is to identify the trend and ride on it till the weight of evidence
indicates that the trend has reversed.
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4. Charts and Charting
Bar Charts:
• Most widely used chart
• Requires data on opening, high,
low and closing prices
• Time series chart -- Daily,
weekly, monthly basis or for any
period
• Single vertical line that
represents the range, a left
horizontal tick that represents
the open and a right horizontal
tick that represents the close
• Can be overlaid with volume and
open interest on the same chart
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5. Charts and Charting
Candle Charts:
• It requires data on open, high, low
and close as well
• Time series chart but differs from a
bar chart in that it has a body that
represents the opening and closing
range and shadows that show the
high and low of the day,
• When open is higher than the
close, the body is black
• When Open is lower than
close, the body is white
• A candle chart is said to provide a
superior signal
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6. Charts and Charting
Point and Figure Charts:
• Allow the user to specify the criteria for significant price movements
• Not a time series chart - it requires only the high and low of the day
• Two parameters are - box size and reversal number
– Box size determines the sensitivity of the chart while the reversal number
specifies the minimum number of boxes that the price trend must change to
terminate one column and initiate a new one
• Advantages:
– It captures intra-day trading better
– Provides a method for calculating price objectives
• Disadvantages:
− Tedious
− Certain price patterns are not shown
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7. Charts and Charting
Point and Figure Charts: (cont..)
• The horizontal count for price
objective is:-
• Price objective = P +/- (W x RV)
– where P = the extreme value
W = the base width excluding
breakout column
RV = the reversal value
• The vertical count is a measure
of volatility and can be used to
determine the size of
retracement after a major price
move.
• Price objective = Extreme box
+/- Number of boxes in first
reversal x minimum number of
boxes in chart reversal.
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8. Dow Theory
• Originally developed by Charles H. Dow to determine the trend direction of
the stock market
• Theory does not forecast the magnitude and duration of the trend
• The theory is popular among chartists for equity markets as well as among
those for other financial markets.
• The limitations of this theory are
– The buy/sell signals are slow by the time confirmation appears
– To overcome this, traders should consider the weight of other evidence and
factors like maturity of cycles and price volume divergence
• There are six Tenets
First Tenet:
• The Averages (industrial and transport) discount everything known to the
market.
• The changes in prices reflect the aggregate judgment of all market
participants, having digested all available facts.
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9. Dow Theory – 6 Tenets
Second Tenet:
• There are three types of movements: primary trends, secondary reactions
and minor movements
• Primary trend lasts less than 1 year to several years
• Main objective of Dow theory is indeed to identify the primary trend where
the significant movement takes place.
• Secondary reactions normally last from 3 weeks to 3 months
• Usual decline in a bull market or advance in a bear market
• Retracements can extend from 33% to 67% of the primary trend
• Minor movements can last from hours to 3 weeks
• Insignificant price changes and so there are little forecasting values
• They merely form parts of primary or secondary moves
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10. Dow Theory – 6 Tenets
Third Tenet:
• Lines (consolidation) indicate price movements of 2 weeks or longer
• Represent narrow price variations approximately 5% of mean
• During Consolidation: market players either accumulate (buying by strong
hands hence bullish) or distribute (buying by weak hands hence bearish)
Fourth Tenet:
• Price and volume relationship: merely background information or additional
evidence of a trend,
• Wether the trend continues or reverses can only be confirmed by prices
Fifth Tenet:
• Price actions determine the trend
• Successive higher peaks and troughs evidence an uptrend while a
downtrend is shown by successive lower troughs and peaks.
Sixth Tenet:
• The Industrial and Transport Averages must confirm each other
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11. Trendlines and Channels, Support and
Resistance
Trendlines:
• Indicate the general direction of market
• Commonly used for identifying support and resistance points
• Connecting at least two successive low points where the latter is higher
than the former draws an up trendline
• Conversely, connecting at least two successive high points where the latter
is lower than the former draws a downtrend line
• Assumption: Existing trend is intact until subsequent closing prices
penetrate the trendline
• Penetration of trendlines can signal reversal, consolidation or continuation
• A trendline is more reliable
– the longer it remains intact and the more times it is tested
– Gradual rather than a steep ascent/descent
• Latest trendline has more influence
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12. Trendlines and Channels, Support and
Resistance - 2
Channels
• Formed by parallel or almost parallel lines connecting the high and low
points
• Channels are also used for identifying points of support and resistance
• The penetration of channels signifies trend acceleration or deceleration
• Sometimes penetration can also signify reversal when price moves out of a
channel only to fall back and break the channel in the opposite direction
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13. Trendlines and Channels, Support and
Resistance - 3
Support Levels
• The price where the majority of investors believe that prices will move
higher
Resistance Levels
• The price at which majority of investors feel prices will move lower
• Penetration of support/resistance
– Can be triggered by fundamental changes that are above or below investor
expectations
– Chart points develop at supports and resistances
– Support once broken will become the resistance for next up move
– Resistance once broken will become the support for the next down move
– Whether a chart point can be breached depend on: Loss cutting, profit taking and
new entry
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14. Volume and Open Interest
• Volume measures the number of contracts traded
– Good indication of the intensity of a move reflecting the demand and supply
– When prices are rising and volume is increasing
• Expect the trend to continue
– When prices are rising but volume is decreasing
• Present trend may not sustain
• Open interest measures the outstanding uncovered contracts
– In a bull market where higher prices are accompanied by increasing open
interest, it means there are new buyers entering the market
• Expect the trend to continue
– As open interest continues to build up, it will eventually reach an overbought
situation
– Open interest can be used in conjunction with other indicators to determine
overbought and oversold conditions
• In general, any sustained move should be backed by prices, increasing
volume and open interest.
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15. Major Chart Patterns: Reversal Patterns
• Reversal Patterns
–Indicate the ending of an existing trend and beginning of a new trend
Head and Shoulders Top:
• Reversal of an uptrend
• Consist of an head and two shoulders
– Head is higher than shoulders
– Right shoulder is formed by a rally on small volume
– The formation is confirmed by breaking of the neckline on a decline from the right
shoulder. This is then a signal to sell.
• Volume is used as an additional confirmation indicator. Sometimes prices
may retrace to the neckline after the break.
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16. Major Chart Patterns: Reversal Patterns - 2
Head and Shoulders Bottom/ Inverted Head and Shoulders:
• Signals that the market is turning bullish and is the opposite of a head and
shoulders top formation.
• Usually observed that the right shoulder declines on light volume but then
rallies on high volume.
Double Top:
• Formed by price move that fails to exceed the previous top
• Followed by a violation of the previous low
• Second top is normally formed on low volume
Double Bottom:
• Is the opposite of double top and indicates that the market has bottomed
and prices will rise after breaching the neckline.
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17. Major Chart Patterns: Reversal Patterns - 3
Triple Top and Bottom:
• A more significant indication of trend reversal than the double top or bottom.
• Occurs less frequently than double top or bottom
• Has the same volume conditions to be valid and measurement of objective
as those of a double top or bottom
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18. Major Chart Patterns: Continuation Patterns
Continuation Patterns
• Shorter in duration and represents pauses in existing trends
Triangle:
• Most common but least reliable pattern
• Has both reversal and continuation
patterns
• 2 main types:
– Symmetrical
– Right angled triangles
• For symmetrical triangle: two converging
lines joining the peaks and troughs form
it
• Right angled triangle: is formed when
one of the lines is perpendicular to the
vertical axis
• A triangle is supposed to show the
direction for the next move
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19. Major Chart Patterns: Continuation Patterns - 2
Triangle (cont.)
• Sometimes does not work as it turns into a rectangle instead
• Symmetrical triangles - preferably have four reversal points under gradually
lower volume conditions, increasing open interest and the first reversal point
should be the highest or the lowest point.
• Right-angled triangles, both ascending and descending, are better
predictors of the future direction of prices than symmetrical triangles.
• To measure price objective assuming a breakout on the upside – draw line
parallel to the lower side of the triangle and expects prices to rally up to that
line
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20. Major Chart Patterns: Continuation Patterns - 3
Wedges:
• Are intermediate continuation or
consolidation patterns,
• For a rising wedge: bearish sign once broken
out of the wedge
• A falling wedge is a bullish sign
• Wedges may take 2-8 weeks to
complete, hence appear only in a weekly
charts
Flags:
• Formed during a narrow band range
• Normally short duration dynamic congestion
phases
• Attraction is: they provide favourable
risks/rewards for trading
• Occur after a sharp straight-line price move
• Represent mid-way consolidation of a move
• Flags normally slopes in the opposite
direction of a trend
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21. Major Chart Patterns: Continuation Patterns
Pennants:
• Develop under similar circumstances as
flags
• Converging, rather than parallel lines like the
flags, bound them
• Should conform to three rules to be
considered valid
– Firstly, they should occur after a very sharp up
or down move.
– Secondly, the volume should decline
throughout the duration of the pattern and
– Finally the prices should breakout of the
pattern within a matter of a few weeks.
• Formula: simply adds the height of the pole,
formed in the move preceeding the formation
to the breakout point of the flag
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22. Major Chart Patterns: Minor Trend Change
Indicators
Minor Trend Change Indicators
• Used to help ascertain price direction for the next few sessions
• Are very short-term indicators
Key reversal day:
• Normally occurs after an extended move,
• Formed when prices have reached a significant new high or low but close in
the opposite direction,
• Accompanied by high volume and declining open interest
Inside range day:
• Occurs when prices move within the range of the previous day
• More importantly it is which wary prices move out of ranges in the following
sessions
Outside day range:
• Formed when day’s high is higher than previous high and the low is lower
than the previous low.
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23. Major Chart Patterns: Gaps
• Technically these are open gaps
where no trading takes place
Common gap:
• This occurs within trading range or
congestion areas and therefore
has very little or no forecasting
value
Breakaway gap:
• Occurs at the completion of a
pattern or a penetration of trendline
• Normally accompanied by high
volume
Island reversal gap:
• Price gap higher or lower, trade in
a narrow range then gap lower or
higher
• Marks the end of a trend
convincingly
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24. Major Chart Patterns: Gaps - 2
Runaway Gap:
• Occurs during a straight line
advance or decline
• Either closes quickly or otherwise
will remain open for a long period.
• Runaway gap happens mid-way of
a price move and hence it is also
called a measuring gap.
Exhaustion Gap:
• A large gap formed after an
extended move
• Marks the end of a trend
• It is hard to identify and we can
assume that it is more likely if price
objectives have been met and
other gaps have been formed
previously.
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25. Statistical Analysis: Moving Average
• Smoothing aims to identify the trend by eliminating unnecessary price
moves.
– Serves to determine only the direction of the trend but, not the extent or objective
of the price move
– It assumes that the trend will continue.
Moving Average (“MA”)
• Derived by continuously computing the average of the most recent n days
of closing prices.
• Can be plotted from the open, high, low, close or average for the day
prices, but closing price is the preferred one.
• Period for the moving average will determine the sensitivity and speed of
trend change.
• Period selected will vary according to the type of commodities analyzed and
the market trend wanted: short, intermediate or primary.
• Moving average can represent areas of support and resistance and the
longer the period the more significant the crossover, similar to trendlines.
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26. Statistical Analysis: Moving Average - 2
Moving Average (“MA”) (cont.)
• Three methods to use MA to evaluate the market
• The MA itself
– When the MA turns, the existing position will be liquidated and a new position in
the opposite direction is initiated.
• The crossover method
– first we plot the prices and superimpose the moving average on the same chart
– whenever the closing price crosses over the MA, a signal is generated crosses
the MA from below, a buy signal is given
– Whenever it crosses the MA from above, a sell signal is indicated
– To prevent being caught in a whipsaw in a range trading market, filters are
adopted - in the form of percentage penetration or period of violation
• Multiple moving averages method
– uses two or more MAs of different periods
– Slower MA is used to identify the trend
– Faster one is used to time the entry and exit points
– Convergence of moving averages indicates temporary balance of buyers and
sellers and warns of imminent big moves
– When the balance is tipped one way or others, market moves very quickly
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27. Statistical Analysis: Moving Average - 3
• Limitation: MA is a lagging indicator
– When signal is generated the trade can only be executed at a price away from
the level of the signal.
– Moreover, MA of closing prices also means that the turning of MA cannot be
ascertained till market close.
• Sometimes market gaps and thus entry levels may not be favorable.
– Unfavourable entry points mean greater price risk
• Inability to execute trades at the market top or bottom limits the usefulness
of the technique to markets experiencing major and sustained moves
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28. Statistical Analysis: Moving Average - 4
• The simple moving average:
• The weighted moving average (WMA):
– More sensitive than SMA hence will generate a timelier signal
– WMA itself changes direction the signal is generated rather than waiting for the
crossover
• The exponential moving average:
– Calculate 5 days exponential moving average
– Exponent = 2/period = 2/5 = 0.4
– Longer the period the less sensitive it becomes
– Sometimes 2 parallel lines are plotted at certain percentage away from the MA to
create an envelope to provide indications when the move is over extended.
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29. Statistical Analysis: Oscillators and Momentum
• Momentum can warn of latent (hidden) strengths or weaknesses in the price
being studied, well ahead of the turning points.
– Refer to rate of change in price or the gradient of the line representing the price
change.
– Used to identify trend reversal and duration of the trend.
– Not able to determine the price objective
• Tools for momentum: Rate of change (“ROC”), MACD, relative strength
index (“RSI”)
• Two types of momentum:
– price momentum and
– breadth momentum
Rate of Change (“ROC”)
• Measures the rate at which prices change over a period of time
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30. Statistical Analysis: Relative Strength Index
Relative Strength Index (“RSI”)
• While ROC does not provide guidelines for high and low, the RSI eliminates
this problem by confining the values within 0 to 100,
• Any value below 30 indicates oversold while any value above 70 indicates
overbought,
• advantage of RSI over ROC is that it takes out erratic movements by
averaging the price change
• There are 4 general interpretations of momentum (see next slide)
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31. Statistical Analysis: Relative Strength Index - 2
Overbought and oversold
• Sometimes prices could exceed these extremes for a long period of time.
• By waiting for prices to go into oversold or overbought areas and fall back
before decisions are made, it allows the signal to be filtered first.
Divergence between price and momentum charts
• Implies a weak technical structure and corrections may be due soon
• Merely warns of weakening market conditions and is not a signal to sell.
• Confirmation: violation of trendlines, crossover of moving average or price
pattern formation.
Complex divergence
• Uses two momentum indicators of different time spans
• By overlaying two momentum indicators from two different time spans we
can compare them and look for divergences between them
Trendline violation
• Both momentum and prices need to break their trendlines to confirm trend
reversal
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32. Elliot Wave Theory
• Developed from observations that all natural phenomena repeat themselves
in regular rhythms
– It assumes that markets will move forward in a series of five waves then retraces
in series of three waves
• Drawback of the method is that it is subjective
– User needs to judge the beginning and ending of waves
– Involves recognition of the current market position within completed form, and
– To anticipate the likely paths for the market - once waves of a smaller degree are
recognised, waves of the next higher degree can be anticipated.
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33. Elliot Wave Theory - 2
•Wave 1 - This represents the end of
the correction and the market
turning point.
•Wave 2 - Wave 2 is normally
accompanied by an oversold
reading in oscillators.
•Wave 3 - This is the most powerful
and explosive move and the longest
in distance.
•Wave 4 – It is also often equal to
Wave 2
•Wave 5 – It is equal to Wave 1
•Waves A, B, C - These are the
retracement Waves
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34. Cycle Theory
• Movement in financial markets depends on attitudes of investors on the
business cycle;
– Different markets peak and trough during different points of business cycle
– During expansion interest rates rise and bond prices drop, but stocks continue to
rise so long as profits continue to increase.
– Stocks start to turn down when investors feel that further improvement in
earnings is limited,
– Gold may still go up as inflation, a lagging indicator, continues to rise though the
economy has slowed.
– Therefore, what happened is that the stock market is expected to peak after the
bond market peaks and followed by the gold market.
• Relationship between different market cycle are signposts as to the future
direction of different financial instruments.
– But it is difficult to predict the time lead/lag between the different financial
instruments
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35. Random Walk Theory
• In an efficient market, prices are said to move in a random manner and as
such any attempts to predict future prices will be futile.
• There are three hypotheses under this theory:
– Weak form
• Under this hypothesis, it is believed that past price records do not hold
definite relationships to future prices.
• Forecasting on this basis is therefore useless.
– Semi-strong form
• Historical price relationships have no value and therefore cannot be used to
extrapolate future prices.
– Strong Form
• All material information is embedded in current prices and has no impact on
future prices.
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36. Contrarian Theory
• Technique of holding a view opposite to what is prevalent and generally
believed by the majority of market players.
• Assumes that the majority, i.e. the crowd, is unable to think rationally and
intelligently due to crowd psychology and a false sense of security would
creep in
• This is particularly useful in stock prediction as some classes of investors
are traditionally wrong.
• Moreover, when demand is strong, the next shift in sentiment is more likely
to lower demand.
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37. Contrarian Theory - 2
• Contrarian Indicators
– Odd lot trading
• Assumes that small odd lot traders are usually wrong at market extremes
– Short/long interest
• If the ratio of shorts to longs is great, then the market is bullish, and vice versa. Such
information can be deduced from open interest figure.
– Mutual funds cash level
• When mutual funds are bearish on stocks they hold more cash.
• Additional cash implies future buying power and so the market is likely to move up then
down.
– Put/call ratio
• Higher puts to calls ratio is due to bearish sentiment. But it also makes the next move
more likely to be up.
– Investment advisory sentiment
• Sentiment is bullish, it’s time to sell as most likely the professional investment
community is already long in stocks.
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